Managing longevity risk Working with Towers Watson

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Innovation

Clie

nt-fo

cused solutions

Size

and volume

• Our Longevity Direct offering is the first ready-made vehicle for pension schemes to access the longevity reinsurance market• 135 pension schemes and six insurers/ reinsurers use Towers Watson’s market–leading postcode mortality tool

We have advised on:• De-risking transactions covering two-thirds of the liabilities hedged in 2014• Half of all the partial buyout cases completed to date• Over 50% of all longevity swaps ever transacted

• Longevity risk is integrated within investment risk framework to enable active decisions• Streamlined approach for longevity swaps and bulk annuities results in quicker, more efficient transactions

Managing longevity risk is becoming increasingly important and the market is evolving rapidly. Towers Watson has driven innovation in this area and helped schemes to integrate longevity risk into their risk management plans.

Deal of the year

AWARDS 2014

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ForewordThere are £2 trillion of UK defined benefit (DB) liabilities – only £100 billion of these have hedged longevity risk so far. This is an area that continues to grow rapidly both in terms of the size and volume of annuity transactions and longevity swaps, with more innovative ways to access this market being developed.

Increasingly, DB pension schemes are on a de-risking journey, ultimately leading to buy-in or self-sufficiency. While investment risk is measured closely and actively managed, less attention has typically been paid to longevity risk. However, as investment risk reduces over time, managing longevity risk becomes increasingly important. With most schemes wishing to remove longevity risk eventually, it is important that trustees and sponsors consider when and how to manage this risk.

In the pages that follow, we explore how trustees and sponsors can understand and analyse the longevity risks they face and how stochastic modelling can help you to assess the potential impact of future improvements in mortality. Placing longevity risk in a similar framework to investment and other risks enables this important risk to be monitored and managed in a consistent manner.

We also discuss with Ian Aley, our Head of Transactions, the solutions that are available if hedging longevity risk is attractive, how this market is evolving rapidly and why there may be an advantage in acting now.

Finally, we share a case study that explains how one of our clients understood their longevity risk and implemented a new and innovative solution to hedge that risk.

At Towers Watson, we have driven innovation in this area with unrivalled experience in managing longevity risk and implementing longevity risk solutions. Our team brings together a wide range of backgrounds including insurance, investment, pension consulting, and project management, as well as experience working for insurers and investment banks. We work with a wide range of clients, helping them to identify and manage their longevity risk from the smaller to the largest pension schemes, developing tailored solutions for them.

We would welcome the opportunity to discuss with you the changes that are taking place in this increasingly important area, and to work with you to develop a plan that is appropriate for your scheme.

Keith Ashton Head of Risk Solutions +44 1737 274629 keith.ashton@towerswatson.com

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Understanding longevity risk

Figure 01. Trend risk

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Why is longevity risk important? It will be news to no one that over the last decade the average person’s life expectancy has grown. What may be a surprise though is just how great the impact of that change has been on DB pensions: an increase of about 10% to pension scheme liabilities in the last decade alone. That means that if there had been no life expectancy improvements over the last decade, the total FTSE 350 pension deficit would be zero rather than the multiple tens of billions of pounds we see today.

So that’s all in the past. We are where we are and if you have adjusted your scheme’s longevity assumptions, then you’re sorted, right? Well, for now, perhaps. At the current rate of improvement it is projected that the life expectancy for a 65 year old will increase by around two years over the next 20 years. But what if, as in the past, this estimate is wrong? Every additional year of life expectancy for the scheme membership adds 3% to the liabilities.

What is longevity risk?Before considering how to remove or reduce longevity risk, it is important to understand what it is. There are three aspects to longevity risk, the first of which is called trend risk.

Figure 01 shows how the probability of surviving to old age has changed over the years for men. While not much changed between 1850 and 1900, over the next 50 years, the statistic had improved to the point where 90% reached their 40th birthday. Trend risk is the risk that even with all the information available to us at a point in time, we just get it wrong – you can see how far an actuary in 1900 or 1850 might have got it wrong!

As we move on another 50 years and then finally to 2010, we see further improvements. But interestingly, we are not seeing much change in the ultimate age – the human body seems to have a shelf life that we have not been able to extend although there is much debate on this very issue.

Even with the lower rate of improvements, there is still scope for us to get it wrong, which can be financially costly.

“If there had been no life expectancy improvements over the last decade, the total FTSE 350 deficit would be zero rather than multiple tens of billions of pounds.”

Emma Palfreyman

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The second aspect of longevity risk is called idiosyncratic risk. This is the risk that even if mortality rates now and in future were known with certainty, particular individuals or groups live longer than expected. In larger schemes, averaging tends to remove this risk, although even then some schemes could have significant idiosyncratic risk for certain groups, such as highly paid pensioners.

How long are your members living now?Using your scheme’s own experience is the most powerful approach for setting life expectancy assumptions today, although this is not an option for smaller schemes, which do not have sufficient data. However, by analysing your membership’s postcodes and pension amounts using Towers Watson’s Postcode Mortality Tool (see Figure 02), we can link the characteristics of a scheme membership with a much larger experience set. This approach has improved the credibility of assumptions being made significantly. But of course, it’s only an assumption and it could be wrong – this is known as basis risk.

How might this change in the future?As we have seen, it is difficult to predict how fast future improvements might be. Using past trends can only give part of the picture and may result in building in improvements that are unlikely to be repeated. It is important to consider other models, in particular those that investigate developments in disease treatment and prevention that may drive longevity improvements in the future.

Figure 02. Postcode Mortality Tool

How certain can we be about predicting future trends?Once the Scheme Actuary has carried out statistical analysis, decided on a mortality table to fit the observed experience and derived a future longevity assumption, the question to consider is how wrong this assumption might be and the potential financial implications. Stochastic modelling can help to illustrate the potential variability of results. There are a number of different models that can be used to assess longevity risk – based on past experience and looking forward using disease-based mortality.

As we run simulations using these different models, a range of possible cashflows are produced. This enables us to use the type of terminology typically used when assessing investment risk, such as ‘1 in 20 scenarios’ and ‘confidence levels’. Once this is done, we can then consider moving longevity risk into the de-risking framework alongside investment risks. Shelly will explore this aspect further on the next two pages.

22 years 20 years 18 years

Key: Life expectancy at age 65

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Managing longevity risk

Over the last few years, trustees and sponsors have established a journey plan setting out how they expect their scheme to move towards a long-term objective of self-sufficiency or ultimate settlement of the liabilities. Trustees and sponsors will aim to reduce risk along this journey as a scheme matures and funding improves.

The temptation is to reduce the risks that are most familiar and readily modelled: asset risk (largely equities and credit) and on the liability side, interest rate and inflation risk. To date many schemes have yet to quantify the scale of their longevity risk, consider how it compares with other risks and develop a plan for managing it over time.

Holistic risk assessment and management becomes increasingly important as a scheme reduces investment risk, otherwise longevity will quickly become the most dominant risk. And there is no need to wait until you are fully funded against technical provisions or fully de-risked elsewhere; indeed this may be too late. We believe schemes are likely to be much more successful in reaching their long-term objectives if they take a balance of well diversified and rewarded risks, rather than leaving a large concentrated exposure to members living longer than expected to be managed at the end.

Shelly Beard

0% 1% 2% 3% 4% 5%Fall in nominal yields

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Longevity shock

Figure 03. Ranking your key risks

“To date many schemes have yet to quantify the scale of their longevity risk, consider how it compares with other risks and develop a plan for managing it over time.”

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Figure 03 shows the impact of a longevity ‘shock’ on a typical scheme’s funding level – in other words, the impact of an event occurring that has a 1 in 20 chance of happening. In this case, such an event would result in an immediate reduction in the scheme’s funding level of more than 2.5%.

So if we know most schemes will hedge longevity risk at some point over their journey plan, the key question becomes ‘when is the right time to hedge this risk?’ Trustees and sponsors should ensure they are measuring and monitoring longevity risk along the way so they do not look back and say ‘if only’.

For many schemes hedging some longevity risk now will make sense. The first step is to quantify the risk to understand the current position, but, more importantly to understand how the risk evolves over time, using the techniques and tools set out in ‘Understanding longevity risk’ on pages 4 and 5.

Once the size of the longevity risk is known and understood, it can be incorporated into the risk return framework that the scheme uses to assess investment options. This is a lightbulb moment for many, as for the first time the scheme is taking an active decision about how much longevity risk they wish to run, much in the same way as they would with, say, equity risk.

It’s also possible to extend this analysis to consider, for a given funding level and balance of investment risks, what the optimal proportion of longevity risk is to hedge. For the schemes we’ve looked at this analysis for, there is typically a strong theoretical case for hedging between 30% to 50% of the risk – and this conclusion is relatively insensitive to the assumptions used.

As with any analysis, you can construct reasons why you might not want to hedge what the theory says is an ‘optimal’ position, but it does allow you to form a view as to an optimal longevity hedge ratio for you, today (given all the other factors) and in the future. And it is probably not zero!

This has enabled, where appropriate, clients to successfully implement longevity hedging solutions leading to more efficient investment portfolios, with a higher expected return per unit of risk. Figure 04 below shows examples of the solutions that are available in this evolving market. We consider this market in more detail in the following pages.

Figure 04. Examples of market solutions

Bulk annuities Longevity swaps

Medical underwriting

All-risks Scheme owned cell

Top slicing

Partial buyout Direct to reinsurer

Traditional intermediary

Transfer asset and longevity risk Transfer longevity risk

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Q&A – Interview with Ian Aley

Over the last couple of years, there has been a lot of activity and discussion about addressing longevity risk. When should a scheme choose a longevity swap over a bulk annuity?

For smaller schemes, a bulk annuity has proved to be the most appropriate option, although recent developments that are discussed below mean that access to the longevity swap route is now available to more schemes.

For larger schemes, it typically depends on where the scheme is on its journey plan. Earlier in the journey plan the scheme is likely to need the assets in order to achieve investment returns. Any gilts are often required as collateral for interest rate and inflation swaps. By carrying out a longevity swap, the scheme retains control over most of its assets and this will therefore be a more suitable approach than purchasing annuities, which require assets to be available.

The cost of hedging longevity is similar regardless of the chosen approach. Therefore, if a scheme is comfortable with the governance of asset and longevity risks, they could hedge in the same way as a bulk annuity provider would and implement a ‘do-it-yourself’ solution at a lower cost, as there is no need to pay the insurance risk margin on the asset risks. If schemes want to achieve precision in matching their cash-flows, and value the relatively low governance, then bulk annuities are the way to achieve this, although there will be a cost of doing so.

There has been lots of publicity and discussion about longevity swaps recently. What is happening in the bulk annuity market?

The bulk annuity market is currently very competitive and we continue to see transactions of all sizes taking place. Following the 2014 budget statement, and the drop off in individual annuities, several insurers are increasingly focusing their attention on the bulk annuity market. This includes

those providers who previously only offered medically underwritten buy-ins for pensioners, but are now increasing both the type and size of bulk annuity offered. New entrants to the market are also expected.

Combined with this, schemes are increasingly seeing bulk annuities as an investment strategy decision. This is reinforced by the fact that the process for purchasing bulk annuities – of all sizes – is increasingly standardised and streamlined. For example we led a transaction this year where it took just under four months from first approaching the market to completing the buyout.

What is driving the longevity swap market? Why is it so active and will this continue?

This is driven by both supply and demand factors.

On the demand side, many pension schemes are reaching the point in their journey plan where longevity risk is becoming more significant relative to the other risks they’re running. In addition to this, hedging longevity risk has become more affordable – see below.

On the supply side, many reinsurers have a considerable amount of mortality risk on their books – the risk that more people die than expected. By taking on longevity risk – which is the opposite – they get diversification and can reduce their overall reserve requirements.

At the moment, the reinsurers still have much more mortality risk than the £100 billion or so of UK longevity risk that has been transferred – and they are keen to take on longevity risk, which is reflected in their pricing. However, over the medium to long term, and with £2 trillion of UK DB pension liabilities, this position may change. At a conservative estimate longevity demand might average £50-£100 billion of liabilities a year, which based on our estimates of supply, is likely to cause upward pressure on prices over the medium to long term.

Ian Aley Head of Transactions

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What was different about the recent record-breaking BT deal? Are there going to be more like that?

In July 2014, the BT Pension Scheme was the first scheme to access the reinsurance market directly by establishing an insurance cell company owned by the scheme. The structure gave the scheme more direct control over the terms of their longevity insurance and avoided the need to pay an intermediary fee.

For schemes that don’t wish to go to the effort of creating their own insurance cell company from scratch, there are a small number of organisations who could provide a cell for you. For example, over the course of 2014, Towers Watson developed Longevity Direct to allow our clients to efficiently access the reinsurance market through the purchase of a ‘ready-made’ insurance cell company, and at the end of the year MNOPF became our first client to successfully complete a deal through this innovative structure. More details on this – and the first transaction completed through this model – are given on pages 10 and 11. Our view is that this offering will make longevity hedging accessible for more pension schemes.

So if I am at the start of the process, what steps should I be taking?

Firstly, I’d recommend considering what liabilities to hedge – for example part or all of your pensioners – understanding the level of risk that

will be removed and whether a longevity swap or bulk annuity fits best with your journey plan, so that you can decide your preferred strategy. An initial feasibility stage may be appropriate – this typically includes indicative market pricing, considering the funding and accounting implications and general training on the options available.

At the same time, schemes may wish to complete focused data work. A few small steps to ensure data is fit for purpose can make a significant difference to the price charged: here it is important to focus on the items that really add value.

Once these initial steps are completed, the right governance process would need to be put in place – for example a sub-committee to take the transaction forward. For larger transactions, a project manager normally adds value for all stakeholders.

Then select your potential providers and approach the market. Timescales can be quite short – recent buy-in transactions have been completed in a matter of weeks and our most recent longevity swap was finalised in a few months.

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Matt Wiberg

In December 2014, Towers Watson launched Longevity Direct, which enables pension schemes to gain direct access to the reinsurance market in order to hedge longevity risk. Based in Guernsey, Towers Watson Guernsey ICC Limited allows pension schemes to set up a ready-made incorporated cell that can write insurance and reinsurance contracts for longevity swap transactions. Longevity Direct is ideally suited to longevity-hedging transactions where a single reinsurer can take on the whole liability.

Longevity Direct provides an affordable solution by removing the intermediary fee and its credit exposure fee and replacing these with the lower running costs associated with running a cell.

Further benefits to pension schemes of using Longevity Direct would be:

• Simplified governance process • Ability to access a single reinsurer at the best available price

• Facilitates smaller deals but also makes larger deals with a single reinsurer possible

• Efficient and cost effective process

We find that pension scheme and reinsurer interests are typically reasonably aligned; a direct agreement can be much less complex than the longevity swaps we have seen in the past. This reduction in complexity – and therefore the surrounding governance – means reduced costs, both at the initial set up stage and throughout the course of the hedge, which should mean hedging is possible for more schemes.

Longevity Direct – owning your

own insurance cell

TW Guernsey ICC LimitedBeneficiaries

MNOPF IC LimitedMNOPF

Reinsurance market

Reinsurer

Payments based onactual experience

Payments based onactual experience

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Payments based on agreed

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Figure 05. How does Longevity Direct work?

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Case study

MNOPF – managing longevity risk

The Trustee of the MNOPF has a journey plan that aims to fund on a low-risk gilts basis. In reviewing the journey plan, alongside Towers Watson, their investment advisers, they identified that the Section had a concentration of longevity risk.

Towers Watson undertook a stochastic mortality analysis to establish the size of the risk within the Fund. A de-risking budget was agreed with the trustee, reflecting both the optimal level of longevity risk and anticipated market pricing, which suggested undertaking a £1bn longevity hedge.

The trustee approached the market, looking to transact via an insurance cell structure using Towers Watson’s Longevity Direct offering, which enabled them to transact directly with the reinsurance market. See Figure 05.

Towers Watson undertook a competitive quotation process, extracting price tension to achieve better terms. Due to the attractiveness of the pricing received the trustee was able to increase the size of the transaction to £1.5bn with Pacific Life Re, covering all of the pensioners and dependants in the Fund, some 16,000 members.

The Fund set up an incorporated cell, MNOPF IC Limited and entered into the longevity swap in December 2014. Longevity Direct led to a simplified process – the direct negotiations with the reinsurance market meant that the transaction was completed in less than three months from entering exclusivity.

Using this structure has saved MNOPF several millions of pounds in the cost of the hedging. The Fund has now hedged a significant proportion of longevity risk whilst maintaining flexibility over its assets and can continue on its journey plan.

“Longevity was a significant, concentrated risk for the MNOPF and, having considered the different options available, the Trustee Board decided that Towers Watson’s Longevity Direct structure was the most cost effective and efficient structure.”Ensign Pensions & MNOPF Chief Executive, Andy Waring

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Considering longevity hedging is consistent with:

• Longevity risk will be hedged eventually • Longevity hedging will become more expensive over time or an absence of a view around future pricing

• Longevity risk is a significant risk now and there are immediate risk management benefits

• Longevity risk will become material over time and it is sensible to start building a hedge now

• There may be wider benefits (for example, sponsor and investors may see this as good risk management)

• Longevity risk represents a single concentrated risk which is only there due to the liabilities of the scheme (you would not choose to add this to a portfolio if it was not there already)

• The risk saving is worth the governance and associated costs.

Deferring longevity hedging is consistent with:

• The scheme will not hedge longevity risk for many decades

• Longevity risk will become cheaper to insure in the future

• Longevity risk is not a significant risk now or the cost of hedging is disproportionate to the risk

• The scheme does not anticipate de-risking so longevity hedging can be deferred

• There are other reasons not to hedge (for example, sponsor views and impact on accounts)

• The governance and implementation costs are too high to justify starting now.

Should you hedge now or later?

After reading this document you may be asking whether you should hedge or not? The question is really whether you should hedge your longevity now or later. We would advocate making a conscious decision about hedging as you would with your investment risks rather than being caught out by longevity risk later. To help you decide which of these courses of action is right for you now, please read through the two sets of ‘belief statements’ below and decide which best describe your current situation.

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Towers Watson has considerable experience in working with a wide range of clients in analysing, managing and monitoring longevity risk. Here’s why we are best placed to work with you in developing and implementing longevity risk solutions:

Unrivalled experienceWhether you are interested in understanding your longevity risk better, would like to include longevity risk within your risk framework or would like to implement a longevity swap or carry out a buy-in, our experience is second to none in the market.

Strategic adviceWe take a holistic, integrated approach to advice and implementation, bringing together experts in longevity, transactions, investment, retirement, risk, insurance and project management.

InnovationTowers Watson is at the forefront of developments in this area driving innovation from transacting the first collateralised buy-in, first synthetic buy-in and the first longevity swap. Most recently we’ve developed Longevity Direct to allow our clients to efficiently hedge longevity risk, and led the advice to the BT Pension Scheme on setting up their insurance company for the purpose of hedging longevity risk.

Strong relationships with providersThe longevity hedging market is continually evolving, with additional providers entering the market and new products emerging. Keeping close to providers is essential to understand what is available and where they might be appropriate. Towers Watson has built up strong relationships with all the insurers, banks and reinsurers to help navigate the best solution for trustees and sponsors.

Flexible and adaptableWe will work with you to help you understand how longevity risk is relevant to your particular circumstances and develop a tailored solution. Whether the solution is a longevity swap, a partial buy-in or simply monitoring the position, the recommendation will be relevant to you.

Why work with Towers Watson?

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Further information

To find out how you can benefit from using Towers Watson’s longevity solutions, please contact your Towers Watson consultant, or

Ian Aley +44 20 7227 2102 ian.aley@towerswatson.com

Keith Ashton +44 1737 274629 keith.ashton@towerswatson.com

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About Towers WatsonTowers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 15,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Learn more at towerswatson.com